The individual insurance market or any group market that requires an election by one or more individuals, including that for annuities and life insurance suffers from a phenomenon known as adverse selection. This means that individuals with long-lived ancestors and/or healthy and low-risk lifestyles tend to be more likely to purchase products such as annuities that will pay them a guaranteed income (usually a specific amount) for the rest of their lives. Conversely, persons whose ancestors died of natural causes at an early age and/or who live unhealthy or high-risk lifestyles tend to be more likely to purchase products such as life insurance.
These tendencies have led to a predictable result in the pricing of these policies. The persons (typically States in the United States) who regulate insurance companies are concerned with their continued ability to honor the promises and, in this regard, typically insist on the insurance companies utilizing conservative assumptions in the pricing of these products. Also, the companies themselves are very aware of these phenomena and, in this connection, may price their products using assumptions that may even be more conservative than that used by their regulators.
For example, it has been estimated in at least one article “Adverse Selection in Insurance Markets: Policyholder Evidence from the UK Annuity Market, 2004 Journal of Political Economy 112(1) Part 1: 183-208, Amy Finkelstein and James Poterba that roughly half of the difference between what a person pays for an annuity the present value of payouts is due to adverse selection, which based on this article, means that seven and one half to ten percent of the price of this product is based on adverse selection.
Unattractive pricing resulting from the potential for adverse selection means that persons who would otherwise benefit from the purchase of this type of insurance product will do so less frequently than they otherwise would. Further, when they do purchase these products they may not purchase as much as would be optimal because of the effect of adverse selection on pricing. Also, issuers of these products could enhance their profits by reducing or eliminating adverse selection.
This is unfortunate in that many persons would benefit from insurance products with a potential for adverse selection. For most persons who purchase the most commonly known insurance products, life insurance and annuities, this means purchasing a product such as life insurance when they are younger in order to provide for their survivors if they die prematurely, and/or a product such as annuities when they are older to insure against outliving their savings.
A possible solution to this problem includes combining the purchase of insurance products and/or services in a manner that tends to reduce the risks posed by adverse selection. For example, an insurance company or intermediary or a combination of the two could combine or package an annuity together with life insurance and/or disability insurance. Another example could provide that an annuity is purchased, or available for a limited period of time, if another product is purchased either from the insurer or a third party (e.g., money management). The terms of the annuity could then depend on events that are somewhat or totally independent of the insurance risk such as the birth of a child or the performance of the investment or some benchmark related to the investment. This could mitigate the risk of adverse selection and enable persons who sell insurance products to offer them on a basis that is more attractive than would otherwise be the case.
For example, the system could project the effect on risk if life insurance of various types was sold at the same time as various types of annuities. In one example, a persons who is 30 years old could purchase term life insurance for a term of 30 years and an annuity that begins at age 75 at the same time. Since it is clear that such an individual could not claim benefits under both policies, there is at least some reduction in the risk of adverse selection by combining the two products. If this risk reduction is quantified, it could permit a seller of this combination to sell more products or improve its profits or some combination of the two. By passing along none, all, or a part of the savings to purchasers, this could enable an issuer such as an insurance company to make more profits and possibly more sales by reason of its products being more competitive in the market place.
Combining investment products with insurance products can also be attractive from the standpoint of the insurer if combined with investment products, particularly if there is an objective basis upon which the investment product could be converted to an insurance product since this would be a safeguard against adverse selection. Also the certainty of the conversion would enable insurers to cover the risks of having to provide an insurance product such as an annuity in the marketplace. For example, an insurer that has liability to provide annuities if the price of a certain index reaches a specified level could obtain interests that would enable it to hedge this risk. It could, obtain interests, either through purchase or swaps, that when combined with its existing portfolio and obligations, enable it to be in a better position able to pay the amounts due under its policies. For example it could arrange to swap a part of its portfolio (which could match the index upon which conversion is based in some of its outstanding annuity/investment products) for an option to obtain payments at a given rate of interest if the price of an index met a specified level, if that is the level that triggered an obligation to provide annuities.
The ability to hedge because of the additional certainty provided by this type of contract would permit an insurer to offer better rates on its policies, improve its profits or both when compared with the current methods of issuing annuities. Individuals will be able to purchase new products that better serve their needs at better prices. The present disclosure is then a significant improvement over the products currently being offered in the marketplace.
Yet another approach could be to offer policies that are contingent on significant life events, particularly those that do not have a direct bearing on the risks of the insurer under the policy. In such cases the policies may offer an option to increase or an automatic adjustment on the occurrence of such an event, such as marriage or the birth of a child. For example, in the case of a life insurance policy, the birth of one or more children could result in an increase in coverage. Such a birth could also result in a shift from an annuity to investments when additional funds may be needed to pay for the support of an additional child in the event of the policy holder's death. Another example could be the death of a parent. If the death resulted in a reduction in responsibility this could result in a need for less life insurance and/or a shift from stock investments to an annuity. In the converse, where there is an inheritance this could also result in a lesser need for life insurance since there is additional money to take care of survivors, but a shift to annuities since there is less need to take risk.
Yet another approach is to use automatic procedures to implement the purchase of insurance products alone or in combination with other products. As demonstrated in studies such as that conducted by Hewitt Associates in conjunction with Harvard University and the Wharton School of the University of Pennsylvania, “Enrolling Employees in 401(k) Plans Not a Cure All” more than half of the individuals remained with the automatic or default criteria for deductions from their wages and for investment selection even when there is an opt out available. The inertia that this, and similar studies have found would tend to reduce the risk of adverse selection if automatic procedures were used.
In order to address adverse selection, it is generally anticipated that a purchaser would have to pay for purchase the product or a portion of the product in cash, commit to pay in the future or employ some combination of the two. Given that this may be a major purchase, it could be appropriate to secure the purchase obligation with one or more interests in property that are owned by the persons (e.g., a mortgage on real property) and/or pay for the purchase with amounts that are deducted from the pay of the individual. In cases where the amount is deducted from the pay of individuals, the amount deducted may increase over time and the amount and/or timing of such increases may correspond to a greater or lesser extent to the increased in pay received by the person(s) who pay for the products.